Audit committee requirements

Audit committees of companies that are publicly traded in the United States are subject to rules of the Securities and Exchange Commission (SEC) and listing standards of the exchange on which the company’s securities are listed, such as the New York Stock Exchange (NYSE) or Nasdaq. These include rules and standards related to committee composition, the charter, and committee evaluations. Indirectly, audit committees may be subject to additional requirements resulting from rules and standards for independent auditors under the Public Company Accounting Oversight Board (PCAOB).

Composition

Under NYSE and Nasdaq requirements, the audit committee should consist of three or more directors who are independent as determined by the board. All members must comply with the independence and financial literacy requirements of the SEC, NYSE, and Nasdaq. Audit committees are not required to include an audit committee financial expert as defined by the SEC, but they are required to disclose why they do not have one if that is the case, which encourages audit committees to have at least one member who qualifies as a financial expert. Audit committees should review their composition periodically to confirm that members have the knowledge and experience they need to be effective in their roles.

Under NYSE standards, if an audit committee member simultaneously serves on the audit committees of more than three public companies, the board must determine that such simultaneous service would not impair the ability of the member to effectively serve on the company’s audit committee and must disclose this in the company’s proxy statement. Nasdaq does not have a similar requirement, although many Nasdaq-listed companies have similar policies to respond to investor views or other circumstances.

Independence and qualifications of members

Audit committee members must be independent directors; however, audit committee members are required to meet heightened standards of independence compared with independence standards for other board members. Given these requirements, independence of audit committee members should be continually maintained, monitored, and reviewed at least annually. Listed companies should have policies in place to allow timely identification of changing relationships or circumstances that may affect the independence of audit committee members.

Companies generally require directors to complete independence questionnaires when joining the board and each year thereafter and to notify the company of any changes that may affect independence. For audit committee members, these questionnaires should be tailored to reflect the additional independence criteria required of them. The board should review any relationships or circumstances provided in audit committee members’ responses to these questionnaires and determine whether they impair or could be perceived as impairing independence. Companies may want to involve legal counsel in assessing the independence of audit committee members and other directors.

Diversity of members

Nasdaq requires disclosure of information about the diversity of the company’s board. Companies are required to disclose board-level diversity statistics using a standardized template and explain in cases where they do not have at least two diverse directors. Nasdaq defines diversity as those who self-identify as a female, an underrepresented minority, or LGBTQ+. The rule does not apply to audit committees specifically, but it may serve as a reminder for committees to consider diversity in their composition.

Composition: Common practices and considerations

In designating an audit committee financial expert, the board should abide by the SEC rules and applicable listing requirements and may wish to consult with legal counsel when doing so. Given the complex issues audit committees often address, proactive audit committees often choose to have more than one financial expert. Audit committees might consider using a skills matrix to identify the skills and experience important to their committee considering the growing agendas for many audit committees in areas such as risk, cyber, and environmental, social, and governance (ESG) issues. In making this determination, the board may have audit committee members complete a questionnaire to evaluate whether an individual meets the criteria.

Although financial expert status may not change over time, committee members should invest the effort needed to understand the latest developments in financial reporting and auditing standards, as well as developments affecting the company, particularly in areas the audit committee oversees, to determine whether any changes in composition are warranted. If the committee determines that it’s lacking in a particular skill or capability, the audit committee chair should discuss this issue with the nominating/governance committee, which is responsible for recruiting board members, as it considers board succession planning. Some boards have a process for reconfirming the financial literacy of their audit committee members and revisiting the financial expert designation periodically. It is also important for the board and the audit committee to consider financial literacy and expertise during succession planning.

The SEC requires proxy disclosures about the qualifications of directors and the nomination process. The disclosure includes information about the experience, qualifications, and attributes considered in the nomination process and the reasons why individuals should serve on the company’s board. Disclosures regarding individual board committee qualifications are not required, but companies may want to consider including such qualifications as a part of the overall board qualification disclosure.

Right to engage independent counsel

The SEC, NYSE, and Nasdaq all authorize the audit committee to engage and compensate independent counsel and advisers, as required under the Sarbanes-Oxley Act. The audit committee may use the same counsel and advisers as management, but circumstances may warrant consideration of separate counsel. Lawyers are the outside advisers most often engaged by audit committees and may be engaged to advise on areas such as legal proceedings, corporate governance issues, whistleblower inquiries, fraud concerns, and SEC matters. The services may be investigative, or they may be used to identify potential process improvements.

Charter: Common practices and considerations

Charter: Tools and resources 

To help with planning, audit committees can consider using their charter to create a calendar outlining what might be covered during each meeting over the course of a year, although charters and calendars may not align precisely.

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When updating the charter and calendar, it may be helpful to consult with legal counsel, management, the internal auditors, if any, and the independent auditor. Any recommended changes to the audit committee charter should be presented to the board for approval.

Evaluation and self-assessment

The NYSE listing standards require audit committees to perform an annual performance evaluation, and this responsibility must be included in the audit committee’s charter. SEC and Nasdaq listing standards do not require audit committees to assess their performance, but all audit committees should consider how performance assessments could provide information to enhance their performance and processes.

Evaluation and self-assessment: Common practices and considerations

A well-crafted performance assessment benefits audit committee effectiveness in multiple ways. It can help prioritize agendas and meeting structure to focus on the most critical issues and identify topics for future agendas and continuing education sessions. It can also enable fresh considerations regarding the delivery, level of detail, and quality of materials provided by management. Importantly, the assessment brings focus to the committee’s composition relative to its current and future needs and challenges and can be a catalyst to committee refreshment, if warranted. See a sample self-assessment that audit committees can use to evaluate their performance.

Evaluation and self-assessment: Tools and resources 

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